Executive Pay: A Llingering Challenge

Looking to 2010 and beyond, we need a resolution to how executive pay should be set.

Climate change and a delayed charge by Tiger Woods aside, executive pay took up a large slab of global news time in 2009 engaging professional and amateur investors alike. Like those other issues, the pay controversy remains unresolved at year end.

Unfortunately, the debate about executive pay which risks distracting managers and endangering corporate performance is being unnecessarily prolonged by some of the participants including executives who have been more than a little shy in describing how their pay is set.

Small shareholders, in particular, have found a way to exercise leverage over executives that they otherwise would not have had. Politicians have also been pleased enough to similarly participate. A solution would now reduce their powers. The discussion is now muddled by these competing interests.

In seeking greater clarity, we need to put aside thoughts about levels of pay and focus more on how the pay levels are going to be set.

For example, it could make theoretically good sense for executives to be paid according to their marginal contributions to business performance. However, this could lead to some big numbers.

In an Australian context, a bank like NAB could see a swing in earnings of $2 billion over the tenure of a chief executive. Even a payment of just 5% of the amount added under his tenure might cause far too much public relations anguish for it to be seriously contemplated.

But the principle still holds with one important and often under emphasized qualification which makes all the difference. If an executive was attracted to a job by the upside potential of an earnings linked remuneration package, he should also acknowledge his potential role in any earnings downside.

Executive payments should be symmetric. In the event of an earnings slide, the CEO should be committed to recovering fully the loss before he is again eligible for any performance based payments. If he decides to leave before fulfilling this obligation, he should automatically forgo all termination payments. Any earlier earnings-related payments should also be subject to a claw back provision.

If this was the choice, many executives would eschew the upside and settle for more modest - and more certain - payments. The capacity of executives to define asymmetric pay packages for themselves has contributed greatly to a blowout in pay.

This is an important guidepost for shareholders: don't quibble about size. Offer executives as much as they want in the way of pay upside but demand that they take a symmetric exposure on the downside or no job.

For many, tying pay to share price movements is the solution. This is more muddled thinking. Few chief executives have shown that they understand what influences share prices let alone have had the capacity to determine their outcome.

A company's value is set, in part, by its future earnings stream but also, in part, by the capitalization rate set by the market. The latter will be driven by macroeconomic conditions and is more likely to be influenced by Ben Bernanke than by Michael Chaney.

At different points in an economic cycle, markets might apply a multiple to earnings of anything from 12 to 18. Let's say an executive joins a company when earnings are $100 and when the market values a company at 12 times earnings. Let's say, also, that he leaves when earnings are $110 and the market price to earnings ratio is 18. The share price would have gone up by 65%.

Company shareholders, in these circumstances, would probably be more disposed toward rewarding their executives well but the manager would have only contributed 10 percentage points of the 65 percentage point rise.

Since the macroeconomic influence on earnings can frequently outstrip the impact of individual executives, share price related remuneration is correspondingly undeserved. There is no logic in giving executives large payments because of actions by the European central bank or the U.S. Fed. This idea is greatly flawed.

Options which are leveraged exposures to these macroeconomic outcomes are even less worthy of consideration.

An alternative but surprisingly little used method of payment is a task based one with executives paid agreed amounts for completing projects or meeting pre-specified goals. Whether that work adds to share prices is largely out of their control and should not be treated as their responsibility.

Shareholders, meanwhile, assume the macroeconomic risks. They invest to take advantage of lower interest rates, exchange rate changes or policy shifts which might have an effect on value.

When executives also want to take these risks, they should be free to do so but not with shareholders' money and not in their day to day executive roles.

Creating the impression that executives have an influence out of all proportion to their actual impact on share prices has risked destabilizing business. Until clearer guideposts are established reflecting more accurately the role of executives in a corporation, executive pay will remain as contentious as ever.

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